Name: Natya Nindyagitaya

Student ID: 141521573

Summary Chapter 11
Auditing Inventory, Goods and Services,
and Accounts Payable: The Acquisition and Payment Cycle

A. Significant Accounts, Disclosures, and Relevant Assertions

The significant accounts in the acquisitions and payment cycle are inventory, cost of goods sold,
accounts payable, and other related expense accounts. Inventories are items of intangible property that
are held for sale in the ordinary course of business, that are in the process of production for such sale.

1. Activities Involved in the Acquisitions and Payment Cycle

Requisition (formal purchase) of goods and services
Purchase of goods and services
Receipt of, and accounting for, goods and services
Approval of items for payment
Cash disbursement

2. Relevant Financial Statement Assertions

Assertions Relevant to Inventory
Existence/occurrence inventory balances exist at the balance sheet date
Completeness inventory balances include all inventory transactions that have taken place
during the period
Rights and obligations the organization has title to the inventory as of the balance sheet date
Valuation or allocation the recorded balances reflect the true underlying economic value of
those assets
Presentation and disclosure inventory is properly classified on the balance sheet and disclosed
in the notes to the financial statements

Assertions Relevant to Accounts Payable

Existence/occurrence accounts payable balances exist at the balance sheet date
Completeness accounts payable balances include all accounts payable transactions that have
taken place during the period
Rights and obligations the organization actually owes a liability for the accounts payable as of
the balance sheet date
Valuation or allocation the recorded balances reflect the true underlying economic value of
those liabilities
Presentation and disclosure accounts payable is properly classified on the balance sheet and
disclosed in the notes to the financial statements

B. Performing Risk Assessment Procedures in the Acquisitions and Payment Cycle

Information that are useful in assessing the risk of material misstatement are information about inherent
risks at the financial statement level and at the account and assertion levels, fraud risks, strengths and
weaknesses in internal control, and results from planning analytical procedures.

1. Identifying Inherent Risks

 Inventory is a complex accounting and auditing area because of the following:
A great variety of items exists in inventory
Inventory accounts typically experience a high volume of activity
Inventory accounts may be valued according to various alternative accounting valuation methods
Inventory is easily transportable
etc

2. Identifying Fraud Risk Factors

Examples of fraud in the acquisition and payment cycle include:
Theft of inventory by the employee
Inventory shrinkage: a reduction in inventory presumed to be due to physical loss or theft
Employee schemes
Employees recording fictitious inventory or inappropriately recording higher values for existing
inventory
etc

3. Identifying Control Risks

Overview of Internal Controls for Accounts in the Acquisition and Payment Cycle
A well-conceived inventory control system should provide reasonable assurance of the following:
All purchases are authorized
There exists a timely, accurate, and complete recording of inventory transactions
Receipt of inventory is properly accounted for and independently tested to verify quality in
adherence to company standards
The cost accounting system is up-to-date

Specific internal controls in this cycle typically include:

A periodic inventory system a system of inventory recordkeeping in which no continuous
record of changes in inventory is kept
A perpetual inventory system a system of inventory recordkeeping where book inventory is
continuously in agreement with inventory on hand within specified time periods
Cycle counts (periodic testing of the accuracy of the perpetual inventory record) are taken as part
of the perpetual inventory system
etc

Typical controls for each of the five activities of the acquisition and payment cycle:
Requisition (Request) for Goods and Services
The acquisition process for inventory begins with the companys production or sales plan.
Important controls in requisition include a production plan and authorization of a requisition
form that is sent to an approved vendor by a purchasing agent or that is sent through the
computer system according to preexisting contracts.

Purchase of Goods and Services

Many companies centralize the purchasing function in a purchasing department. A separate
purchasing function:
- Promotes efficiency and effectiveness
- Eliminates potential favoritism
- Reduce the opportunity for fraud
- Centralizes control in one function
 Important purchasing controls include the approval of a contract with suppliers, restricted access
to the computer program, and monitoring of inventory and purchase levels by management.
Although there are advantages to centralized purchasing, there is a risk that purchasing agents
may enter into kickback arrangements with vendors. Controls to mitigate this risk include
requiring competitive bids for large purchases and rotating purchase agents across product lines.
Companies may consider additional controls, such as:
- A maximum quantity that can be ordered within a given time period
- A minimum amount of previous usage during a specified time period
- A required review by a purchasing agent for some accounts or for high-dollar levels.

Receipt of, and Accounting for, Goods and Services

Receiving departments should make sure that only authorized goods are received, that the goods
meet order specifications, that an accurate count of the goods received is taken, and that
accountability is established to assure that all receipts are recorded. Several alternative methods
of recording the receipt of goods include:
- The receiving department prepares prenumbered receiving documents to record all receipts
- The receiving department electronically scans bar codes on the goods received to record
quantity and vendor and then visual inspects the goods for quality
- Departments may receive goods directly
- Goods are received directly into the production process

Approval of Items for Payment

Approval typically involves a three-way match, a control in which a purchase order, receiving
information, and a vendor invoice are matched to determine whether the vendors invoice is
correct and should be paid. If all items on the three documents properly match, the vendors
invoice is set up as an account payable with a scheduled payment date. The traditional approach
to controlling the receipt of, and payment for, purchases is labor intensive and error prone. The
automated matching process which use computerized application represents an efficient
alternative by matching the three documents (purchase order, receiving document, and vendor
invoice), and if the three-way match is within a prespecified tolerance limit, the invoice is
approved for payment. The lack of human intervention is compensated for by control procedures
and authorization concepts built into the automated system such as: authorized vendors,
restricted access, automatic process, reconciliations inherent in the process, automation of error-
prone activities, restricted access to transferring funds, and monitoring.

Cash Disbursement
The most important controls in these systems:
- Review of transactions
- The direction of vendor disputes to someone outside the process

4. Performing Planning Analytical Procedures

There are some steps in planning substantive analytical procedures, they are:
Step 1: Identify suitable analytical procedures
Step 2: Evaluate reliability of data used to develop expectations
Step 3: Develop expectations
Step 4 and Step 5: Define and identify significant unexpected differences
Step 6 and Step 7: Investigate significant unexpected differences and ensure proper documentation

5. Responding to Identified Risks of Material Misstatement

 Audit procedures should be proportional to the assessed risks, with areas of higher risk receiving
more audit attention and effort. Responding to identified risks typically involves developing an audit
approach that contains substantive procedures and tests of controls, when applicable.

C. Obtaining Evidence About Internal Control Operating Effectiveness in the Acquisitions and Payment
Cycle
1. Selecting Controls to Test and Performing Tests of Controls
The auditor will select both entity-wide and transaction controls for testing. Typical tests of
transaction controls include inquiry of relevant personnel, observation of the control being
performed, inspection of documentation confirming that the control has been performed,
examination of documentation corroborating that the control has been performed, and reperformance
of the control by the auditor testing the control. Many tests of controls involve computerized
controls, for example, an automated three-way match. Here, the auditor may test whether the control
was operating effectively by taking a sample of payments and tracing them to documentation
corroborating that the control has been performed. Attribute sampling would likely be used to
determine and select the sample.

2. Considering the Results of Tests of Controls

The auditor will analyze the results of the tests of controls to determine additional appropriate
procedures. There are two potential outcomes:
If control deficiencies are identified, the auditor will assess those deficiencies to determine their
severity.
If no control deficiencies are identified, the auditor will likely determine that the preliminary
assessment of control risk as low is still appropriate.

D. Obtaining Substantive Evidence About Accounts, Disclosures, and Assertions in the Acquisitions and
Payment Cycle
1. Substantive Tests of Inventory and Cost of Goods Sold
Here, the auditor seeks reasonable assurance that inventory exists, that it is owned by the company,
and that the value of inventory is accurate. Substantive procedures should be performed for all
relevant assertions related to significant acquisition and payment cycle accounts and disclosures.

Inventory and Cost of Goods Sold: Substantive Analytical Procedures

Before performing tests of details, the auditor may perform substantive analytical procedures, such
as a reasonableness test. An example of a reasonableness test would be to estimate the account
balance and to determine whether that amount is close to what the client has recorded. If the
auditors expectations are significantly different from what the client has recorded, the auditor needs
to follow up with sufficient appropriate tests of details. If the auditors expectations are not
significantly different from what the client has recorded, the auditor may be able reduce tests of
details.

Inventory and Cost of Goods Sold: Existence/Occurrence Assertion

Auditing standards require auditors to observe the client taking physical inventory in order to obtain
assurance about the existence of inventory. Besides, the auditor should apply analytical procedures
to cost of goods sold to determine if any unexpected significant variations occur.
Complete Year-End Physical Inventory
If a year-end inventory is taken, the auditor should:
- Review the clients procedures for the physical
- Observe the client personnel taking inventory to determine the accuracy of the procedures
 - Make selected test counts that can later be traced into the clients inventory compilation
- Test the clients inventory compilation by tracing test counts to the compilation and
independently test the clients computation of extended cost
- Look for evidence of slow-moving, obsolete, or damaged inventory that may need to be
written down to lower of cost or market

Inventory and Cost of Goods Sold: Completeness Assertion

The auditor typically performs a cutoff test of receipts and shipments of inventory at year-end to
determine whether all items are recorded in the correct time period. The cutoff test is usually
accomplished by capturing information on the last items shipped and received at year-end and
examining samples of transactions recorded in the sales and purchases journals near year-end.
Allowance for Returns
In most situations, the expected amount of returns is not material. But, when such returns are
material to the overall financial presentation, allowances for returns should be established and
the gross profit on the original sale reversed.

Inventory and Cost of Goods Sold: Rights and Obligations Assertion

Auditor should review long-term contracts to determine obligations to take delivery of merchandise,
customer rights to return merchandise, or buy-back obligations, inquire about and gain an
understanding of any inventory held on consignment.

Inventory and Cost of Goods Sold: Valuation or Allocation Assertion

Use the combination of tests of details and substantive analytical procedures to determine inventory
valuation. The auditor should verify the correct cost of inventory and then test for lower cost of
market valuation.
Direct Tests of Product Costs
Any differences noted between vendor invoices and recorded amounts should be identified as an
error and should be projected to the population as a whole using statistical sampling to determine
whether the misstatement might be material. If the company uses a standard cost system, the
costs are verified by tests of the cost system and by tracing the selected items to standard costs.
Tests for Obsolete Inventory (Net Realizable Value Tests)
Determining the amount that should be written off because of obsolescence is a difficult and
challenging audit task because:
- The client will usually state that most of the goods are still salable at current selling prices
- Net realizable value is only an estimate
Auditors often investigate items that appear to be obsolete by reviewing sales subsequent to year-
end and discussing future sales prospects with management.
Testing a Standard Costing System
Testing a Perpetual Inventory System
Using the Work of a Specialist or Expert When Auditing Inventory
For example, a specialist might be needed to determine the physical characteristics in
determining quantities relating to inventory on hand or condition of minerals, mineral reserves,
or materials stored in stockpiles.

Inventory and Cost of Goods Sold: Presentation and Disclosure Assertion

The auditor reviews the clients proposed disclosure for compliance with the guidelines established
by the relevant accounting literature. A number of financial disclosures are required for inventory:
Inventory valuation method used and the percentage of inventory valued under each method
Changes made in the method of valuing inventory
 FIFO or current cost if the inventory is valued using LIFO
Composition of inventory as to raw materials, work-in-process, and finished goods
Purchase commitments that could have an adverse effect on future financial results
The auditor reviews the clients inventory footnote for completeness and accuracy. Most of the
information described in the notes will be independently verified by the auditor in the process of
completing the audit, and the data will be contained in the audit documentation.

Fraud-Related Substantive Procedures for Inventory and Cost of Goods Sold

Observe all inventory locations simultaneously
Confirm inventories at locations that are outside the entity
Compare carrying inventory amounts to recent sales amounts
Examine consignment agreements and determine that consignments are properly accounted for
etc

2. Substantive Tests of Accounts Payable and Related Expense Accounts

The auditors major concern with accounts payable is that the account will be understated. the testing
to be performed depends on the risk of an understatement of accounts payable. If there is little risk,
the testing might be limited to substantive analytical procedures. The auditor could compare ending
accounts payable balance by major vendor to prior year balances, or to the volume of activity during
the year. If there is no balance for a vendor that in previous years was significant, the auditor would
want to consider why that would be the case. When evaluating evidence regarding expense accounts,
the auditor should consider that management is more likely to: (1) understate rather than overstate
expenses and (2) classify expense items as assets rather than vice versa. Therefore, the most relevant
assertion related to expenses in the acquisition and payment cycle is also the completeness assertion.

Accounts Payable and Related Expense Accounts: Substantive Analytical Procedures

When the auditor has concluded that control risk is low for expense accounts, the primary
substantive tests may be substantive analytical procedures. In conducting analytical procedures, the
auditor should recognize that many account balances are directly related to the clients volume of
activity.

Accounts Payable and Related Expense Accounts: Existence/Occurrence

Analytical Review of Related Expense Accounts
To determine if the accounting data indicate a potential misstatement of expense.
Testing Subsequent Disbursements
To determine whether the disbursements are for goods and services applicable to the previous
year and, if so, whether a liability was recorded in the previous year.

Accounts Payable and Related Expense Accounts: Completeness

Reconciling Vendor Statements or Confirmations with Recorded Payables
The auditor reconciles the vendors statement or confirmation with the clients accounts payable
trial balance. This generates reliable evidence, but it is costly, and is used when there is a high
risk that the company does not pay vendors on a timely basis.
Related Expense Accounts
The most widely used approaches to detailed testing of expenses is to either
- Have the client create a schedule of all larger items making up the expense account to be
examined
- Use audit software to
 Examine randomly selected items from expense account using sampling
Prepare a list of all credits to the expense items for further review

Accounts Payable and Related Expense Accounts: Rights and Obligations

Organizations are increasingly entering into long-term contracts to purchase inventory at fixed prices
or at a fixed price plus inflation adjustments. The contracts should be examined to determine
penalties associated with default, and the auditor should gain sufficient knowledge to assess the
clients estimate of the probability of contract default or losses.

Accounts Payable and Related Expense Accounts: Valuation or Allocation

Verifying the mathematical accuracy of the accounts and agreeing them to general ledger and
supporting documentation.

Accounts Payable and Related Expense Accounts: Presentation and Disclosure

There is relatively little that is usually disclosed in the footnotes about accounts payable and related
expense accounts. Rather, these accounts usually just appear on the face of the financial statements.

Review of Unusual Entries to Expense Accounts

The vast majority of transactions to expense accounts should be debits that are accompanied by
purchases of goods and services that can be validated through independent receipts and independent
vendor invoices. The exceptions to this rule are accounts that represent estimates or accounts that are
based on a relationship with specific asset or liability accounts.

Fraud-Related Substantive Procedures for Accounts Payable and Related Expense

- Send blank confirmations or electronic confirmations via confirmation.com to vendors that ask
them to furnish information about all outstanding invoices, payment terms, payment histories,
and so forth.
- Scan journals for unusual or large year-end transactions and adjustments
- Review clients vendor files for unusual items
- Obtain and examine documentation for payments of invoices that are for amounts just under the
limit that typically requires some level of approval.

Documenting Substantive Procedures

- Substantive analytical procedures conducted, conclusions reached, and related actions that were
taken
- Evidence about physical inventory observations for all material amounts
- Evidence pertaining to net realizable valuable calculations
- Evidence from inventory specialists
- Vendor statements